THE AGENCY THEORY

1. Explain the Agency theory

Agency theory is a management and economic theory that attempts to explain

relationships and self-interest in business organisations. It describes the relationship
between principals/agents and delegation of control. It explains how best to organise
relationships in which one party (principal) determines the work and which another party
(agent) performs or makes decisions on behalf of the principal (Jensen and Meckling,
1976; Schroeder et al., 2011

Agency Theory originated from the 1960s & 1970s, economists explored risk sharing
among individuals or groups. This literature described the risk sharing problem as one
that arises when co-operating parties have different attitudes toward risks. Agency
Theory broadened this risk sharing literature to include the so called agency problem
that occurs when co-operating parties have different goals and division of labour.
Specifically, this theory is directed at the ubiquitous agency relationship, in which one
party delegates work to another agent who performs that work. Agency Theory
attempts to describe this relation using the metaphor of a contract. Agency Theory
suggests that the firm can be viewed as a nexus of contracts (loosely defined) between
resource holders.
Examples include;

Conflicts between managers and shareholders: To address the conflict of interest

between shareholders and management, it is important to stress that even within the
same class of shareholders, there may be conflicts, this conflict may relate to what
proportion of the company’s profit should be paid in the form of dividend and what
proportion should be retained for future investments and for capital investment
purposes. Other potential conflicts may involve company’s ethical policies, its
corporate and social responsibilities policies. The agency theory, considering the
potential conflicts of interest between shareholders and management may arise as a
result of several factors, some of such factors include: Reward to management Risk
attitudes of management and shareholders Takeover decisions by management Time
horizon of management

Self-interested behaviour: Agency theory suggests that, in imperfect labour and

capital markets, managers will seek to maximize their own utility at the expense of
corporate shareholders. Agents have the ability to operate in their own self-interest
rather than in the best interests of the firm because of asymmetric information (e.g.,
managers know better than shareholders whether they are capable of meeting the
shareholders' objectives) and uncertainty (e.g., myriad factors contribute to final
outcomes, and it may not be evident whether the agent directly caused a given
outcome, positive or negative). Evidence of self-interested managerial behaviour
includes the consumption of some corporate resources in the form of perquisites and
the avoidance of optimal risk positions, whereby risk-averse managers bypass
profitable opportunities in which the firm's shareholders would prefer they invest.
Outside investors recognize that the firm will make decisions contrary to their best
interests. Accordingly, investors will discount the prices they are willing to pay for the
firm's securities.
The interest of shareholders may include:
• Increasing earnings per share (EPS), and current share prices
• Increasing investor ratios such as dividend per share (DPS), dividend cover,
dividend yield, price-earning (P/E) ratio
Others may include the company improving its corporate and social responsibilities
Management interest may include:
 Managing the firm to achieve its objectives
• Increasing the wealth and size of the company, by expanding the company’s
activities, the bigger the size of the company they manage the better they are
perceived to be.
• Increasing their personal wealth by paying themselves high remunerations and
other benefits
Costs of shareholder-management conflict: Agency costs are defined as those costs
borne by shareholders to encourage managers to maximize shareholder wealth rather
than behave in their own self-interests.
There are three major types of agency costs:
(1) Expenditures to monitor managerial activities, such as audit costs;
(2) expenditures to structure the organization in a way that will limit undesirable
managerial behaviour, such as appointing outside members to the board of directors or
restructuring the company's business units and management hierarchy
(3) Opportunity costs which are incurred when shareholder-imposed restrictions,
such as requirements for shareholder votes on specific issues, limit the ability of
managers to take actions that advance shareholder wealth.

Mechanisms for dealing with shareholder- manager conflicts: There are two polar
positions for dealing with shareholder-manager agency conflicts. At one extreme, the
firm's managers are compensated entirely on the basis of stock price changes. In this
case, agency costs will be low because managers have great incentives to maximize
shareholder wealth. It would be extremely difficult, however, to hire talented
managers under these contractual terms because the firm's earnings would be affected
by economic events that are not under managerial control. At the other extreme,
stockholders could monitor every managerial action, but this would be extremely
costly and inefficient. The optimal solution lies between the extremes, where
executive compensation is tied to performance, but some monitoring is also
undertaken. In addition to monitoring, the following mechanisms encourage managers
to act in shareholders' interests: (1) performance-based incentive plans, (2) direct
intervention by shareholders, (3) the threat of firing, and (4) the threat of takeover.
Stockholders versus creditors: a second agency conflict: In addition to the agency
conflict between stockholders and managers, there is a second class of agency conflict
between creditors and stockholders. Creditors have the primary claim on part of the
firm's earnings in the form of interest and principal payments on the debt as well as a
claim on the firm's assets in the event of bankruptcy. The stockholders, however,
maintain control of the operating decisions (through the firm's managers) that affect
the firm's cash flows and their corresponding risks. Shareholder-creditor agency
conflicts can result in situations in which a firm's total value declines but. Its stock
price rises. This occurs if the value of the firm's outstanding debt falls by more than
the increase in the value of the firm's common stock
Agency versus contract: although the notions of agency and contract are closely
intertwined, some academics bristle at the suggestion they are essentially the same. A
conventional view holds that agency is a special application of contract theory.
However, some argue that the reverse is true: a contract is a formalized, structured,
and limited version of agency, but agency itself is not based on contracts

Agency and ethics: Since agency relationships are usually more complex and
ambiguous (in terms of what specifically the agent is required to do for the principal)
than contractual relationships, agency carries with it special ethical issues and
problems, concerning both agents and principals. Ethicists point out that the classical
version of agency theory assumes that agents (i.e., managers) should always act in
principals' (owners') interests. However, if taken literally, this entails a further
assumption that either: (a) the principals' interests are always morally acceptable ones
or (b) managers should act unethically in order to fulfil their "contract" in the agency
relationship. Clearly, these stances do not conform to any practicable model of
business ethics.
Key idea
• Principal-agent relationships should reflect efficient organization of information and
risk-bearing costs Unit of analysis
• Contract between principal and agent Human assumptions
• Self-interest
• Bounded rationality
• Risk aversion Organizational assumptions
• Partial goal conflict among participants
• Efficiency as the effectiveness criterion Information asymmetry between principal
and agent Information assumption
• Information as a purchasable commodity contracting problems
• Agency (moral hazard and adverse selection)
• Risk sharing Problem domain
• Relationships in which the principal and agent have partly differing goals and risk
preferences (e.g., compensation, regulation, leadership, impression management,
whistle-blowing, vertical integration, transfer pricing)
2. Describe the various types of agency problems.

The agency problem is a conflict of interest inherent in any relationship where one party is
expected to act in another's best interests. In corporate finance, the agency problem usually
refers to a conflict of interest between a company's management and the company's
stockholders

The agency problem does not exist without a relationship between a principal and an agent.
In this situation, the agent performs a task on behalf of the principal. Agents are commonly
engaged by principals due to different skill levels, different employment positions or
restrictions on time and access. For example, a principal will hire a plumber — the agent —
to fix plumbing issues. Although the plumber‘s best interest is to collect as much income as
he can, he is given the responsibility to perform in whatever situation results in the most
benefit to the principal.

The theory attempts to deal with the following problems namely;

How to align the goals of the principal so that they are not in conflict. The first involves the
conflict between the firm’s owners and its hired managers. Here the owners are the principals
and the managers are the agents. The problem lies in assuring that the managers are
responsive to the owners’ interests rather than pursuing their own personal interests. An agent
may be motivated to act in a manner that is not favourable for the principal if the agent is
presented with an incentive to act in this way. For example, in the plumbing example, the
plumber may make three times as much money by recommending a service the agent does
not need. An incentive (three times the pay) is present, and this causes the agency problem to
arise.

That the principal and agent reconcile different tolerances for risk. The second agency
problem involves the conflict between, on one hand, owners who possess the majority or
controlling interest in the firm and, on the other hand, the minority or no controlling. Here the
no controlling owners can be thought of as the principals and the controlling owners as the
agents, and the difficulty lies in assuring that the former are not expropriated by the latter.
While this problem is most conspicuous in tensions between majority and minority
shareholders.it appears whenever some subset of a firm’s owners can control decisions
affecting the class of owners as a whole. Thus if minority shareholders enjoy veto rights in
relation to particular decisions, it can give rise to a species of this second agency problem.
Similar problems can arise between ordinary and preference shareholders, and between senior
and junior creditors in bankruptcy (when creditors are the effective owners of the firm).

The third agency problem involves the conflict between the firm itself—including,
particularly, its owners—and the other parties with whom the firm contracts, such as
creditors, employees, and customers. Here the difficulty lies in assuring that the firm, as
agent, does not behave opportunistically toward these various other principals—such as by
expropriating creditors, exploiting workers, or misleading consumers. In each of the
foregoing problems, the challenge of assuring agents’ responsiveness is greater where there
are multiple principals and especially so where they have different interests, or
‘heterogeneous preferences’ as economists say.

Multiple principals will face coordination costs, which will inhibit their ability to engage in
collective action. These in turn will interact with agency problems in two ways. First,
difficulties of coordinating between principals will lead them to delegate more of their
decision-making to agents.

Second, the more difficult it is for principals to coordinate on a single set of goals for the
agent, the more obviously difficult it is to ensure that the agent does the ‘right’ thing.

Coordination costs as between principals thereby exacerbate agency problems. Law can play
an important role in reducing agency costs.
 2. Discuss the solutions to the various type of agency problem

Incentivizing Employees: If agents are acting in accordance with their own interests,
changing incentives to redirect these interests may be beneficial for principals. For
example, establishing incentives for achieving sales quotas may result in more
salespeople reaching daily sales goals. If the only incentive available to salespeople is
hourly pay, employees may have an incentive discouraging sales. Creating incentives that
encourage hard work on projects benefiting the company generally encourages more
employees to act in the business's best interest. By aligning agent and principal goals,
agency theory attempts to bridge the divide between employees and employers created by
the principal-agent problem.

Standard Principal-Agent Models: Financial theorists, corporate analysts and economists

often use principal-agent models to study and offer solutions for problems that result from
conflicts of interest in business arrangements. These models are constructed to spot and
minimize costs.

An agency relationship: exists whenever one party's actions affect his own welfare and the
welfare of another party in a contractual relationship. Most agency experts attempt to design
contracts that can align the incentives of each party in a more efficient manner. Traditionally,
such contracts result in unintended consequences, such as moral hazard or adverse selection.
(For related reading, see: What is the difference between moral hazard and adverse
selection?)Principal-agent models form the basis of agency theory. Agency theory states that
labour and knowledge are imperfectly distributed (asymmetrical) and that additional
measures are necessary to correct these distributive inefficiencies.

Agency Theory: Agency theorists have always assumed a large role for explicit incentive
mechanisms, such as written contracts and monitoring, to mitigate agency problems. History
demonstrates that these solutions are incomplete based on moral hazard and adverse
selection.

Principal-agent problems contain elements of game theory, the theory of the firm and legal
theory. For example, game theory demonstrates limits for otherwise rational self-enforcement
mechanisms. Economist Ronald Coase argued as early as 1937 that market price mechanisms
are suppressed by transaction costs inherent in hierarchical corporate structure.

Through the years, several different corporate-specific mechanisms have been identified as
possible solutions through agency theory. For example, in 2013, Apple began requiring senior
executive employees and board of director’s members to own stock in the company. This
move was intended to align executive interests with those of shareholders. Management, in
theory, no longer benefits from actions that harm shareholders as the significant investment
owned by executive’s forces them to view their own interests as being identical to investor
interests. Executives, hired by shareholders to represent the best interests of the company and
therefore the best interests of investors, must pay attention to issues impacting the company's
health and long-term growth. Apple believes this effort to address the principal-agent
problem can improve profitability for investors and keep the company competitive for the
future.
Market for Corporate Control: The most frequent example of market discipline for corporate
managers is the hostile takeover; bad managers damage shareholders by failing to realize a
corporation's potential value, providing an incentive for better management to take over and
improve operations.

System of Reputations: A powerful force in every voluntary market, the reputation

mechanism provides an incentive for coordinating the actions of parties with limited
information and trust. There are dozens of examples of reputation-based associations, the
broadest of which is classified as corporate culture.
Other examples include the Better Business Bureau, Underwriters Laboratories, consumer
unions, watch groups and other consumer agencies that reinforce reputation constraints.

Economic Calculation and Competition: Ultimately, individual corporate management is

disciplined by other competitive managers. All management competes for shareholder equity,
and shareholders who feel the loss of mismanagement have an incentive to switch ownership
toward better management.
Agency theory has only recently come to recognize the role of dynamic capital and money
markets in solving agency problems. Inefficiencies in corporate operations create a form
of arbitrage opportunity for entrepreneurs, through reputation-creating organizations or
takeovers, to move capital toward better management.

Law can play an important role in reducing agency costs. Obvious examples are rules and
procedures that enhance disclosure by agents or facilitate enforcement actions brought by
principals against dishonest or negligent agents. Paradoxically, mechanisms that impose
constraints on agents’ ability to exploit their principals tend to benefit agents as much as—or
even more than—they benefit the principals. The reason is that a principal will be willing to
offer greater compensation to an agent when the principal is assured of performance that is
honest and of high quality. To take a conspicuous example in the corporate context, rules of
law that protect creditors from opportunistic behaviour on the part of corporations should
reduce the interest rate that corporations must pay for credit, thus benefiting corporations as
well as creditors. Likewise, legal constraints on the ability of controlling shareholders to
expropriate minority shareholders should increase the price at which shares can be sold to no
controlling shareholders, hence reducing the cost of outside equity capital for corporations.
And rules of law that inhibit insider trading by corporate managers should increase the
compensation that shareholders are willing